Don't let it get away!

LONDON -- As the world's second‑largest tobacco company, and the market leader in more than 50 countries worldwide, British American Tobacco (LSE: BATS) (NYSEMKT: BTI) is a business with very definite attractions. A 63 billion-pound FSTE 100 (UKX) constituent, last year the company earned a pre-tax profit of 4.9 billion pounds on revenues of 15.4 billion pounds.

And with margins like that, it's no wonder that this defensively positioned business is popular with many investors. Today, with its shares changing hands at 3,254 pence, the company is rated on a prospective price-to-earnings ratio of 14 and offers income investors a tempting forecasted dividend yield of 4.5%.

But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in BAT adversely affect investors' wealth?

In this series, I set out to help investors answer just these questions. My starting point: BAT's latest annual report, where the company's directors are obliged to address the issue of risk.

Risk managementOne immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.

The good news? As you'd expect from a business of BAT's size and caliber, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.

But what, precisely, are those risks that the company faces?

Read the small print, and BAT identifies no fewer than eight risks as having a significant prospective impact on the company's financial performance. They range from health-based regulation (such as plain packaging) to high taxes, and from smuggling to geopolitical tensions.

So let's take a look at three of the biggest.

Illicit tradeBAT reckons that the global volume of illicit trade is around 12% of consumption, fueled by high taxes on tobacco products encouraging "illegal" production and selling, and by differing cross-border tax regimes encouraging smuggling and the "gray market."

The dangers are obvious: lower volumes and reduced profits, diminution of pricing power, erosion of brand equity, and the emergence of a commoditized product. Worse, the company worries that illicit trade is on the rise, powered by what it describes as "sudden and disproportionate excise increases, and widening excise differentials between markets," and by the unintended consequences of regulation, such as plain packaging and display bans. As BAT puts it:

Illicit trade, in the form of counterfeit products, smuggled genuine products, and locally manufactured products on which applicable taxes are evaded, continues to represent a significant and growing threat to the legitimate tobacco industry. The risk is exacerbated where current economic conditions have resulted in high unemployment and/or reduced disposable incomes. In the next 10 years, we believe that the problem is likely to increase, driven by the increased regulatory and compliance burden for legitimate manufacturers and fueled by further significant excise increases.

What can BAT do about it? More than you might think. The company points to dedicated anti‑illicit-trade teams operating at global, regional, area and key market levels; strong customer approval policies (to deter selling-on in the gray market); and cross‑industry and multisector cooperation on a wide range of anti‑illicit-trade issues.

In addition, the company's anti‑illicit-trade Intelligence Unit -- which possesses a dedicated analytical laboratory -- cooperates with law enforcement agencies in pursuit of priority targets and illicit tobacco growth and production.

Health-based regulationSmoking kills -- or at least, that's the message that governments are forcing tobacco companies to print on their packets. Advertising is banned in many countries, smoking in the workplace and public places is banned or discouraged, and plain packaging and display bans are around the corner. As BAT puts it:

The group's businesses operate under increasingly stringent regulatory regimes around the world. Further regulation is expected, particularly as a result of the World Health Organization's Framework Convention on Tobacco Control (FCTC) protocol and, increasingly, active tobacco control activities outside the FCTC. There is a risk that the enactment of regulation that is not evidence-based will put the group at a competitive disadvantage, interfere with its ability to differentiate its products, and increase costs and complexity.

I think that the reference to regulation that isn't "evidence-based" somewhat misses the point, but there's no doubt that BAT is worried about what it coyly calls "the denormalization of smoking."

What can it do about it? Watch the regulatory environment like a hawk, in short. According to the company, "Engagement is sought with scientific and regulatory communities within the context of the FCTC process, and stakeholder engagement takes place at global, regional, and individual market levels."

In addition, a dedicated "regulatory futures" team monitors regulatory trends and developments and analyzes regulatory proposals to determine their impacts, if any, on the business -- and tries to develop initiatives in response.

Excise and taxAsk an economist, and you'll learn that a rise in a product's price tends to result in a reduction in the demand for it. And the price that consumers pay for BAT's products is heavily affected by the excise duties and taxes levied on them.

The bad news for BAT: These taxes are rising steeply, to the point where the company is talking about "excise shocks." As BAT puts it:

Tobacco products are subject to substantial excise and sales taxes in most countries in which the group operates. In many of these countries, taxes are generally increasing, but the rate of increase varies between countries and between different types of tobacco products. A number of significant excise shocks have taken place over the past two years, for example in Romania, Turkey, Malaysia, Mexico, and Japan.

What can BAT do about it? To date, says the company, it has been able to balance these shocks with its geographic spread, and it actively engages with governments and tax authorities to seek mitigation.

But, as it notes, the long-term prognosis isn't good: Increases in taxes are often advocated within the context of national health policies -- and governments everywhere, very evidently, are under pressure to raise revenues.

Risk vs. rewardTwo superstar investors who are well used to weighing risks are Neil Woodford and Warren Buffett.

On a dividend-reinvested basis over the 15 years to Dec. 31, 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of more than 20% per annum since 1965, transforming himself into the world's third-wealthiest person.

Each, as it happens, is the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.

So click here to download this free special report profiling the investment logic behind eight of Woodford's largest and most successful current picks.

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